Financial Markets and Institutions

Abridged 10th Edition

by Jeff Madura

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18

Bank Regulation

Chapter Objectives
describe the key regulations imposed on commercial
banks
explain capital requirements of banks
explain how regulators monitor banks
explain the issues regarding government rescue of
failed banks
describe how the Financial Reform Act of 2010 affects
commercial bank operations
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Background
1. Bank regulation is needed to protect customers who
supply funds to the banking system.
2. Many regulations were removed or reduced over time,
which allowed banks to become more competitive.
3. Because of deregulation, banks have considerable
flexibility in the services they offer, the locations where
they operate, and the rates they pay depositors for
deposits.
4. Some banks and other financial institutions engaged in
excessive risk taking in recent years, which is one the
reasons for the credit crisis in the 2008-2009 period.
3

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Regulatory Structure

Often referred to as a dual banking system because it

includes both a federal and a state regulatory system.
A charter from either a state or the federal government is
required to open a commercial bank in the United States.
A bank that obtains a state charter is referred to as a
state bank; a bank that obtains a federal charter is known
as a national bank.
National banks are required to be members of the Fed.
State banks may decide whether they wish to be
members of the Federal Reserve System.

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Regulatory Structure

Regulators
National banks are regulated by the Comptroller of the
Currency, while state banks are regulated by their
respective state agency.

Banks that are insured by the Federal Deposit

Insurance Corporation (FDIC) are also regulated by th
FDIC.

Regulation of Bank Ownership

Commercial banks can be either independently owned or
owned by a bank holding company (BHC).
5

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Regulation of Bank Operations

Regulation of Deposit Insurance

Federal deposit insurance has existed since the creation in 1933 of the
FDIC in response to the bank runs that occurred in the late 1920s and
early 1930s.
The FDIC preserves public confidence in the U.S. financial system by
providing deposit insurance to commercial banks and savings
institutions.

Insurance Limits - The specified amount of deposits per

person insured by the FDIC was increased from
$100,000 to $250,000 as part of the Emergency
Economic Stabilization Act of 2008.

Risk-Based Deposit Premiums - Banks insured by the

FDIC must pay annual insurance premiums.
6

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Regulation of Bank Operations

Regulation of Deposits
1. DIDMCA - Depository Institutions Deregulation and
Monetary Control Act
Enacted to deregulate the banking (and other depository
institutions) industry.
Also enacted to improve monetary policy.

2. Garn-St. Germain Act

Permitted depository institutions to offer money market
deposit accounts (MMDAs).
Permitted depository institutions (including banks) to
acquire failing institutions across geographic boundaries.
7

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Regulation of Bank Operations

Regulation of Deposits (Cont.)

3. Interstate Banking Act
Removed interstate branching restrictions and thereby
further increased the competition among banks for
deposits.
Nationwide interstate banking enabled banks to grow and
achieve economies of scale.

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Regulation of Bank Operations

Regulation of Bank Loans

Regulation of Highly Leveraged Transactions
As a result of concern about the popularity of highly
leveraged
loans
bank regulators
monitor
the amount
of highly
leveraged
transactions
(HLTs), loans
in which
liabilities
are greater
than
75 percent of assets.
Regulation of Foreign Loans
Monitor a banks exposure to loans to foreign countries.
Regulation of Loans to a Single Borrower
Banks are restricted to a maximum loan amount of 15 percent
of their capital to any single borrower (up to 25 percent if the
loan is adequately collateralized).
9

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Regulation of Bank Operations

Regulation of Bank Loans

Regulation of Loans to Community
Banks are regulated to ensure that they attempt to
accommodate the credit needs of the communities in which
they operate.
The Community Reinvestment Act (CRA) of 1977
(revised in 1995) requires banks to meet the credit needs of
qualified borrowers in their community, even those with
low or moderate incomes.

10

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Regulation of Bank Operations

Regulation of Bank Investment in Securities

Banks are not allowed to use borrowed or deposited
funds to purchase common stock.
Banks can invest only in bonds that are investmentgrade quality (as measured by a Baa rating or higher by
Moodys or a BBB rating or higher by Standard & Poors).

11

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Regulation of Bank Operations

Regulation of Securities Services

The Banking Act of 1933 (The Glass-Steagall Act)
separated banking and securities activities. Firms that
accepted deposits could not underwrite stocks and
corporate bonds.

Financial Services Modernization Act (The Gramm

Leach-Bliley Act)
Repealed the Glass-Steagall Act.
Since 1999, there has been more consolidation of financial
institutions.

12

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Regulation of Bank Operations

Regulation of Insurance Services

In 1998, regulators allowed the merger between Citicorp
and Travelers Insurance Group
This paved the way for the consolidation of bank and
insurance services.

13

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Regulation of Bank Operations

Regulation of Off-Balance Sheet Transaction

Bank exposure to off-balance sheet activities has
become a major concern of regulators.
Banks could be riskier than their balance sheets indicate
because of these transactions.
Regulation of Credit Default Swaps
Regulators increased their oversight of this market and
asked commercial banks to provide more information about
their credit default swap positions.

Regulation of the Accounting Process

The Sarbanes-Oxley (SOX) Act was enacted in 2002 to
ensure a transparent process for financial reporting.
14

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Regulation of Capital
Banks are subject to capital requirements, which force
them to maintain a minimum amount of capital (or
equity) as a percentage of total assets.
Banks commonly boost their capital levels by retaining
earnings or by issuing stock to the public.
Banks can increase their capital by reducing their
dividends.
When bank regulators of various countries develop their
set of guidelines for capital requirements, they are
commonly guided by the recommendations in the Basel
accords.
15

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Regulation of Capital

Basel I Accord

16

1988: The central banks of 12 major countries agreed to

establish uniform capital requirements.
Banks with greater risk are required to maintain a higher
level of capital, which discourages banks from excessive
exposure to credit risk.
Banks required to have a capital ratio of at least 8 percent
and a Tier 1 capital ratio of at least 4 percent.
Tier 1 capital consists of shareholders equity, retained
earnings, and preferred stock
Tier 2 capital includes loan loss reserves (up to a specified
maximum) and subordinated debt.
Assets are weighted according to risk.
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Regulation of Capital

Basel II Framework
Refines risk measures and increases transparency.
Revising the Measurement of Credit Risk
Categories are refined to account for differences in risk levels.
Explicitly Accounting for Operational Risk
Initially, banks would be allowed to use their own methods for
assessing their exposure to operational risk.
The committee plans to develop a more sophisticated process
for assessing operational risk over time.
Implementation of the Basel II Framework
Provisions of the Basel II framework are not directly
enforceable.
17

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Regulation of Capital

Basel III Framework

Recommends narrowing the Tier 1 capital definition to
include only retained earnings and common stock.
Calls for higher capital requirements to offset bank
exposure due to derivative positions.
Recommends that banks boost their capital during
favorable economic conditions in order to create a larger
cushion for periods during weaker economic conditions.
Recommends the use of stress tests to determine how a
banks performance and capital level would be affected
should economic conditions deteriorate..
18

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Regulation of Capital

Use of the VaR Method to Determine Capita

Requirements
The capital requirements to cover general market risk are
based on the banks own assessment of risk when
applying a value-at-risk (VaR) model.
A bank defines the VaR as the estimated potential loss
from its trading businesses that could result from adverse
movements in market prices.
Testing the Validity of a Banks VaR - assessed by
comparing the actual daily trading gains or losses to the
estimated VaR over a particular period.
19

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Regulation of Capital

Use of the VaR Method to Determine Capita

Requirements (Cont.)
Limitations of the VaR Model
Generally ineffective at detecting the risk of banks during the
credit crisis.
The use of historical data from before 2007 did not capture the
risk of mortgages because investments in mortgages during
that period normally resulted in low defaults.
Bank-Imposed Stress Tests
Some banks supplement the VaR estimate with their own stress
tests.
20

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Regulation of Capital

Use of the VaR Method to Determine Capita

Requirements (Cont.)

Regulatory Stress Tests during the Credit Crisis

Forecasting the likely effect on the banks capital levels if the
recession existing at that time lasted longer than expected.
Potential impact of an adverse scenario such as a deeper
recession varies among banks.
Government Infusion of Capital during the Credi
Crisis
The Troubled Asset Relief Program (TARP) addressed
financial problems experienced by financial institutions with
excessive exposure to mortgages or mortgage-backed
securities.
21

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How Regulators Monitor Banks

CAMELS Ratings
Capital adequacy
Asset quality
Management
Earnings
Liquidity
Sensitivity
Each characteristic is rated on a 1-to-5 scale, with 1 indicating
outstanding and 5 very poor.
Banks with a composite rating of 4.0 or higher are considered to
be problem banks.
22

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How Regulators Monitor Banks

Capital Adequacy
Because adequate bank capital is thought to reduce a
banks risk, regulators determine the capital ratio (typically
defined as capital divided by assets).
Banks with higher capital ratios are therefore assigned a
higher capital adequacy rating.
Fair value accounting is used to measure the value of
bank assets.

23

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How Regulators Monitor Banks

Asset Quality
Each bank makes its own decisions as to how deposited
funds should be allocated, and these decisions determine
its level of credit (default) risk.
The Fed considers the 5 Cs to assess the quality of the
loans extended by a bank, which it is examining:
Capacity - the borrowers ability to pay.
Collateral - the quality of the assets that back the loan.
Condition - the circumstances that led to the need for funds.
Capital - the difference between the value of the borrowers
assets and its liabilities.
Character - the borrowers willingness to repay loans as
measured by its payment history on the loan and credit report.
24

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How Regulators Monitor Banks

Management
Regulators specifically rate the banks management according
to administrative skills, ability to comply with existing
regulations, and ability to cope with a changing environment.

Earnings
A profitability ratio used to evaluate banks is return on assets
(ROA), defined as after-tax earnings divided by assets.

Liquidity
If existing depositors sense that the bank is experiencing a
liquidity problem, they may withdraw their funds, compounding
the problem.
25

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How Regulators Monitor Banks

Sensitivity
Regulators assess the degree to which a bank might be exposed
to adverse financial market conditions.

Limitations of the CAMELS Rating System

Because there are so many banks, regulators do not have the
resources to closely monitor each bank on a frequent basis.
Many problems go unnoticed.

26

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How Regulators Monitor Banks

Corrective Action by Regulators

Regulators may examine banks frequently and and discuss
with bank management possible remedies
Regulators may request that a bank boost its capital level or
delay its plans to expand.
They can require that additional financial information be
periodically updated to allow continued monitoring.
They have the authority to remove particular officers and
directors of a problem bank if doing so would enhance the
banks performance.

27

They can take legal action against a problem bank if the bank
does not comply with their suggested remedies.
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How Regulators Monitor Banks

Funding the Closure of Failing Banks

If a failing bank cannot be saved, it will be closed.
When liquidating a failed bank, the FDIC draws from its
Deposit Insurance Fund to reimburse insured depositors.
The cost to the FDIC of closing a failed bank is the
difference between the reimbursement to depositors and
the proceeds received from selling the failed banks
assets.

28

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Government Rescue of Failing Banks

Argument for Government Rescue

If all financial institutions that were weak during the credit
crisis had been allowed to fail without any intervention,
the FDIC might have had to use all of its reserves to
reimburse depositors.

How a Rescue Might Reduce Systemic Risk

The financial problems of a large bank failure can be
contagious to other banks.
The rescue of large banks might be necessary to reduce
systemic risk in the financial system, as illustrated next.

29

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Government Rescue of Failing Banks

Argument against Government Rescue

When the federal government rescues a large bank, it sends a
message to the banking industry that large banks will not be
allowed to fail.
Some critics recommend a policy of letting the market work,
meaning that no financial institution would ever be bailed
out.

Government Rescue of Bear Stearns

Bear Stearns had facilitated many transactions in financial
markets, and its failure would have caused liquidity problems
The Fed provided short-term loans to Bear Stearns to ensure
that it had adequate liquidity.
30

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Government Rescue of Failing Banks

Failure of Lehman and Rescue of AIG

In September 2008, Lehman Brothers was allowed to go
bankrupt without any assistance from the Fed even
though American International Group (AIG, a large
insurance company) was rescued by the Fed.
One important difference between AIG and Lehman
Brothers was that AIG had various subsidiaries that were
financially sound at the time, and the assets in these
subsidiaries served as collateral for the loans extended by
the federal government to rescue AIG.
The risk of taxpayer loss due to the AIG rescue was low.
31

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Financial Reform Act of 2010

Mortgage Origination
Requires that banks and other financial institutions granting
mortgages verify the income, job status, and credit history of
mortgage applicants before approving mortgage applications.
Sales of Mortgage-Backed Securities
Requires that financial institutions that sell mortgage-backed
securities retain 5 percent of the portfolio unless it meets
specific standards that reflect low risk.
Financial Stability Oversight Council
Responsible for identifying risks to financial stability in the
United States and makes recommendations that regulators
can follow to reduce risks to the financial system.
32

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Financial Reform Act of 2010

Orderly Liquidation
Assigned specific regulators to determine whether any
particular financial institution should be liquidated.
Calls for the creation of an orderly liquidation fund that can
be used to finance the liquidation of any financial institution
that is not covered by the FDIC

Consumer Financial Protection Bureau

Responsible for regulating consumer finance products and
services offered by commercial banks and other financial
institutions, such as online banking, checking accounts, and
credit cards.
33

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Financial Reform Act of 2010

Limits on Bank Proprietary Trading
Mandates that commercial banks must limit their
proprietary trading, in which they pool money received
from customers and use it to make investments for the
banks clients.

Trading of Derivative Securities

Requires that derivative securities be traded through a
clearinghouse or exchange, rather than over the counter.

34

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Global Bank Regulations

Each country has a system for monitoring and regulating
commercial banks.
Most countries also maintain different guidelines for
deposit insurance.
Differences in regulatory restrictions give some banks a
competitive advantage in a global banking environment.

35

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SUMMARY
Banks must observe regulations on the deposit
insurance they must maintain, their loan composition, the
bonds they are allowed to purchase, and the financial
services they can offer. In general, regulations on
deposits and financial services have been loosened in
recent decades in order to allow for more competition
among banks.
Capital requirements are intended to ensure that banks
have a cushion against any losses. The requirements
have become more stringent and are risk adjusted so
that banks with more risk are required to maintain a
higher level of capital.
36

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SUMMARY (Cont.)
Bank regulators monitor banks by focusing on six criteria:
capital, asset quality, management, earnings, liquidity,
and sensitivity to financial market conditions. Regulators
assign ratings to these criteria in order to determine
whether corrective action is necessary. When a bank is
failing, the FDIC or other government agencies consider
whether it can be saved. During the credit crisis, many
banks failed and also Lehman Brothers failed, but the
government rescued American International Group
(AIG). Unlike Lehman brothers, AIG had various
subsidiaries that were financially sound at the time, and
the assets in these subsidiaries served as collateral for
the loans extended by the government to rescue AIG.
37

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SUMMARY (Cont.)
In July 2010, the Financial Reform Act was implemented.
It set more stringent standards for mortgage applicants,
required banks to maintain a stake in the mortgage
portfolios that they sell, and established a Consumer
Financial Protection Bureau to regulate consumer
finance products and services offered by commercial
banks and other financial institutions.

38

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